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TRENDS IN CORPORATE GOVERNANCE:

A GLOBAL PERSPECTIVE

Bulent Gultekin

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Acknowledgements:

n This presentation is based on a working paper by S. N. Kaplan and Bengt Holmstrom, “The State of U.S. Corporate Governance 2004”, Graduate School Of Business, University of Chicago, 2004. This paper also contains a good list of references for the topics in discussed in this presentation.

n I also benefited from discussions with Herwig Langohr of INSEAD. He generously shared his class notes and public lectures with me.

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Introduction

n Impressions from media is not favorable. For a casual observer corporate governance system is in terrible shape.

n Corporate governance in the USn How it performedn How it changed over the last 20 years

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Definition

n Corporate governance deals with the economic and legal mechanism to foster corporate value creation and proper sharing of it with outside investors by resolving agency problems and information asymmetries between shareholders and managers subject to the constraints of the legitimate interests of other stakeholders

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Topics of Discussion

n How bad is U.S corporate governance?n Changes in US corporate governance over the

last 20 yearsn Recent regulatory changesn NYSE and NASDAQ corporate governance rulesn What will the future bring?n Concluding remarks

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How bad is U.S. corporate governance?

Stock Market Performance Through December 2002

-200%

0%

200%

400%

600%

800%

1000%

1200%

1400%

From 1982 From 1987 From 1992 From 1997 From 2001

U.SEuropePacific

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How bad is U.S. corporate governance?

Stock Market Performance Through Dec. 2002

-200%0%

200%400%600%800%

1000%1200%1400%

1600%1800%

From 1982 From 1987 From 1992 From 1997 From 2001

U.SUKFranceGermanyJapan

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How bad is U.S. corporate governance?

Changes in Real GDP per Capita

0%

10%

20%

30%

40%

50%

60%

70%

1982-2000 1987-2000 1992-2000 1997-2000

U.SUKFranceGermanyJapan

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How bad is U.S. corporate governance?

n Not so bad!n Glass is half empty or half fulln Why is there such outcry about corporate

governance?n Is it because of lack of performance?n Is it because of management fraud after

recent scandals?

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Changes over the last 20 years

n Before 1980Managers as representatives of corporation

n After 1980sManagers as representatives of shareholders

n Three key areasIncentive/compensation for managersShareholder activity/monitoringBoard activity/monitoring

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Before 1980

n Managers focused on growth based measures, such as EPS

n Managers represent the corporationn Goal is not share value maximization but to

ensure growth of the firm by “balancing” the claims of all stakeholders:employees, suppliers, local communities, shareholders

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Before 1980n Management stock ownership was lown Stock options were very lown Only 20% of executive compensation was tied to

stock performancen Raiders and hostile takeovers were uncommonn Proxy fights were seldom usedn Boards were dominated by management

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Before 1980

n Wedge between actual and potential corporate performance was wide

n Large excess capacity in oil and other industriesn Limited ownership of stock and stock ownership

gave little incentive to management for changen Conglomerations and diversification strategies

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1980’sn Institutional ownership was increasingn Use of junk bondsn LBO's (leveraged buyouts) up to 80% of total capitaln Between 1984 to 1990, over $500 equity was retiredn Bust-up transactions to focus on core competenciesn Most extensive market driven corporate restructuringn Legislative help for management which made takeovers

more costly in 1990s

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1980s

n LBO’s are based on three insights

1. High equity incentives for managers(if you pay peanuts, you get monkeys)

n 2. High debt

n 3. Close governance by going private

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1990’s

n Build-up transactions to take new opportunities in new technologies and markets

n Use of equity rather than debt n Trend toward decentralizationn More nimble corporate structures for large

corporations and higher-powered employee incentives

n Boundary between managers and markets has shifted. Managers cede authority to the markets, the scope and independence of their decision-making narrowed

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Changes in Executive Compensationn In 1980s executive compensation is differentn In early 1980’s median compensation for S&P500

companies was $1 million (less than investment bankers)n From 1980 to 1994, average compensation for CEOs of

large U.S corporations tripled in real terms.n Equity based compensation was 20% of total.n From 1994-2001, CEO pay doubled and equity based

compensation is up to 63% of totaln Median compensation for S&P500 firms was $7 million

and ten highest paid CEOs had option grants of $170 million each

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Changes in Executive Compensationn Increases in executive compensation, options in

particular, have generated enormous controversyn One recent survey concludes: “It is widely

recognized… that these options are at best an inefficient financial incentive and at worst create new incentive or conflict-of-interest problems of their own”

n Jealousy?

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Positive side of Executive Compensationn On the positive side:n Performance of the U.S. stock market and strong

growth in productivity provide no support for such arguments

n It aligned the interests of CEOs and management teams with shareholders’ interest. CEOs become more receptive to value enhancing transactions

n Venture capital and private equity firms offer large equity based compensations. True for LBO's.

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Problems with Executive Compensationn Problems with equity based compensation:n Creates incentives to manage and manipulate

accounting numbers to inflate stock valuationn Much of the compensation is very liquid unlike

LBO or private equity sponsorsn Most options are issued at the money and are not

expensed. Ten most highly rewarded CEOs had $170 million options per person. They are also owners such as Larry Ellison of Oracle, Tom Siebel of Siebel Systems, Steve Job of Apple

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Change in Shareholdersn Large institutional investors. From 1980 to 1996,

large institutional investors doubled their share of the overall market from 30% to more than 50%

n SEC reduced the costs to shareholders to challenge management teams.

n Shareholder activity has increased as a consequence

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Changes in the Board of Directors

n J. Lorsch and E. MacIver study recommendations in 1980:

n Board selection by a nominating committeen More equity compensation for directorsn More direct control of board meetings by appointing an

outside chairmann Most of these recommendations are carried out today.n But as Enron, Tyco, WorldCom suggest, there are less

than optimal amount of independence and oversight.

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International Developments

n Similar trends in Europe and also in Asia. There is move toward the U.S model

n In 1999 alone, there were 34 listed companies in Europe received hostile bids representing a total value of $406 billion

n Shareholders’ activism on the risen Repurchase of shares are allowed

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Recent Regulatory Changesn Sarbanes-Oxley Act (SOX)n CEO and CFO return any profits from bonuses and stock

sales if financial reports are subsequently restated because of misconduct.

n Restrictions on insider trading and regulation and enhanced financial reporting. Two day reporting for insider trading instead of 10 days.

n Increased effectiveness of board monitoring. Increased power for audit committee with independent directors

n Increased responsibility for financial reporting and criminal penalties for misreporting

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Effects of Sarbanes-Oxley Act

n Positive effects:n SOX helped to restore confidencen Board auditors have greater powern CEOs and CFOs will have better understanding of

the internal processn Boards will be more sophisticated

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Effects of Sarbanes-Oxley Act

n Negative effects:n Fixed costsn Busy work and diversion of attentionn Ambiguity of some provisionsn More rigid federal regulation from more flexible

state lawn Corporations were instituting these changes

before the SOX was legislated

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NYSE and NASDAQ corporate Governance Rules

n A majority of independent directorsn Larger role for independent directors in

compensation and nominating committeesn Regular meetings of only non-management

directors

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Conference Board Recommendations

n Commission on Public Trust and Private Enterprise for best practices for corporate governance

n Compensation committee should be independentn Performance based compensations should correspond to

long term goalsn Equity based compensation should be reasonable and

cost effectiven Key executives should acquire and hold meaningful

amount of company stockn Compensations disclosure should be transparent and

accounting neutral, i.e. options should be expensed

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Future

n Sarbanes-Oxley Act, the new NYSE and NASDAQ corporate governance rules and Conference Board guidelines will significantly influence U.S corporate governance

n Boards will monitor management more aggressivelyn More independent directors to reduce conflict of interest

questionsn Executive compensation will be subject to more scrutiny.

Restrictions on insider tradingn Options will be expensed

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Conclusions

n Despite all alleged flaws, the U.S corporate governance system has performed reasonably well

n There is no perfect system. We should try to avoid pendulum-like movements so typical of politically inspired system redesigns.